==========================================START OF PAGE 1======
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
SEC v. LEONARD S. Sands, et al.
Civil Action No. 93-7510 JGD (JRx)
Litigation Release No. 15046 / September 16, 1996
Accounting and Auditing Enforcement
Release No. 814 / September 16, 1996
On August 30, 1996, the Honorable Judge John G. Davies,
Central District of California, issued his findings of fact,
conclusion of law, and judgment, in which he found that
defendants Leonard S. Sands ("Sands"), First Pacific Bancorp
("Bancorp"), and PacVen, Inc., violated the anti-fraud and
disclosure provisions of the federal securities laws in
connection with three financing schemes: (1) the fraudulent
funding of the Bancorp offering, (2) the improper recording of
residual interest wrap notes ("RIWNs") as assets and as income on
the consolidated financial statements of the Bancorp, and (3) the
improper recording of unfunded certificates of deposit issued by
the National Bank of Liberia, the central bank of that country,
and then offering them to the public for sale.
1. THE 1987 BANCORP OFFERING
In 1987, the Bancorp offered for sale, pursuant to a
registration statement filed with the Commission, $2.55 million
units in a "mini-max" offering. The prospectus called for a
minimum funding level of $1.5 million. The prospectus also
required the refund of subscriptions if the minimum funding did
not occur.
In November 1987, one month after the minimum was to have
been raised and one month prior to closing, a check in the amount
of $1 million, drawn on the Bank of Montreal through its branch
in the Bahamas, was returned through international banking
channels. Instead of refunding subscriptions proceeds, as
promised by the prospectus, defendant Sands, Chairman of both the
Bancorp and the Bank, bought the $1 million position to save the
offering from failing.
Because Sands, a control person, bought in the offering to
save it, the Court found that defendant Sands' purchase was not a
bona fide investment and accordingly held that Sands and Bancorp
had violated Section 17(a) of the Securities Act of 1933
("Securities Act"), and Section 10(b) and Rules 10b-5 and 10b-9
of the Securities Exchange Act of 1934 ("Exchange Act."). The
Court also found that defendant Sands had failed to file the
requisite Form 4, as required by Section 16(a) of the Exchange
Act and Rule 16a-3 thereunder, and an amendment to Schedule 13D,
==========================================START OF PAGE 2======
as required by Section 13(d) of the Exchange Act and Rule 13d-2
thereunder, for having increased his ownership in Bancorp by over
1%.
Moreover, the Court found that defendant Sands had schemed,
along with defendant Charles W. Knapp ("Knapp"), to divert
$500,000 of offering proceeds of PacVen into the Bancorp
offering. Defendants Sands and Knapp diverted the PacVen offering
proceeds, purportedly in exchange for "commercial paper" issued
by Trafalgar Holdings, Ltd., a Knapp company, through several
other affiliated companies of Trafalgar and into the Bancorp
offering to help reach the minimum. By diverting the funds
through Knapp's companies and into the failed Bancorp offering,
the Court held that defendants Sands and Bancorp violated Section
17(a) of the Securities Act and Section 10(b) of the Exchange Act
and Rules 10b-5 and 10b-9 thereunder. (Defendant Knapp settled
the first day of trial.) The Court also held that Sands violated
Section 17(a) of the Securities Act and Section 10(b) and Rule
10b-5 thereunder because he caused the diversion of PacVen's
offering proceeds into an affiliated company. The registration
statement prohibited affiliated party transactions. Sands was
Chairman of both the Bancorp and Pacven, and he was CEO of both
companies.
Further, the Court found that PacVen's annual report for
1987 and its first two quarterly reports for 1988 contained the
materially false and misleading statement that PacVen had "loaned
$500,000 of the proceeds to an unrelated party, at nine percent
interest, in exchange for a secured promissory note." These
periodic reports were materially false and misleading because the
monies had been diverted (not loaned), the promissory note was
not "secured," and the note was continuously extended without
ever being required to be repaid to PacVen. Moreover, these
reports failed to disclose the material fact that the $500,000
offering proceeds had been diverted and failed to disclose the
affiliate transaction between Bancorp and PacVen. Accordingly,
defendants Sands and PacVen were held to have violated Section
10(b) of the Exchange Act and Rule 10b-5 thereunder. PacVen and
Sands were also held to have violated, without a showing of
scienter, Section 15(d) of the Exchange Act and Rules 12b-20,
15d-1 and 15d-3 thereunder, Sands for having failed to correct
the accuracy of those reports. Further, Sands was held to have
violated Section 20(a) of the Exchange Act.
Finally, the Court held that PacVen violated Section
13(b)(2)(A) of the Exchange Act for failing to maintain accurate
books and records of the disposition of the funds. Sands was
held to have violated Section 13(b)(2)(A) and Rule 13b2-1 and
Section 20(a) of the Exchange Act because he knew or was reckless
in not knowing that PacVen had inaccurately recorded the
diversion as a "loan" and failed to have the records corrected.
==========================================START OF PAGE 3======
See also Exchange act Release No. 33295 (December 7, 1993).
2. THE RESIDUAL INTEREST WRAP NOTES
In September and October 1989, in another effort to make it
appear the Bank was healthy, Bancorp and the Bank acquired eight
RIWNs in exchange for $766,000 cash from the Bank and eight
series of perpetual preferred stock, 100 shares per series, of
the Bancorp. RIWNs are all-inclusive purchase money notes which
wrap around and are subordinate to a HUD mortgage note, the
principal financing instrument for low-income housing projects.
In valuing these RIWNs, however, the Court found that the
methodology and assumptions employed to calculate the present
value of the RIWNs were flawed, among other reasons, because the
defendants relied on inflated appraisals reports on the
underlying HUD projects written at an earlier point in time, for
a different company, and for a different purpose; and because
defendants built into a set of "agreed-upon" procedures to be
applied by Touche Ross, an outside accounting firm, assumptions
designed to overstate the present value of the RIWNs.
Nevertheless, it was these values which formed the basis for the
Bancorp's reporting of the eight RIWNs as assets.
In December 1989, the Bank acquired three additional RIWNs
in exchange for unearned fees from a real estate development
project, which consisted of $1,060,000 in "up-front" consulting
fees and $968,000 in "back-end" success fees (i.e., 50% of the
projected net profit on sale of the completed housing project).
However, Deloitte, Haskins & Sells ("DH&S"), the Bancorp's
independent auditors, advised defendants Sands and Bancorp that
these fees could not be recognized as income because the earnings
process was not complete (i.e., there was little documentary
evidence to show that the services had been performed by year-end
as represented, and there was a question as to their
collectability.) To circumvent these problems, the Bank
"combined" and "re-packaged" the consulting and success fees
under a new label, called "development fees," which the Bancorp
defined in its filings with the Commission as "residual profit
interests in real estate developments." The Bank then swapped
these fees for the three additional RIWNs. By this maneuver, the
Bank recorded revenue in the amount of $1,968,709 -- the exact
amount of consulting and success fees -- on the 1989 Bancorp
financial statements.
The Court found that the Bancorp filed periodic reports with
the Commission which contained materially false and misleading
statements regarding the transaction by which it and the Bank
acquired RIWNs, the description and value of the RIWNs, and the
financial condition of those entities. In addition, the Court
found that the improper inclusion of the RIWNs in the financial
statements in the 1989 10-K and March 1990 10-Q allowed Bancorp
to convey the false impression that Bancorp's financial condition
was improving when, in fact, it had deteriorated materially.
==========================================START OF PAGE 4======
The Court found that defendants Sands and Bancorp pumped up
shareholders' equity and assets simply by issuing the perpetual
preferred stock of the Bancorp. In the consolidated financial
statements incorporated in its annual report for the fiscal year
ending December 31, 1989 ("1989 10-K") and in a quarterly report
for the period ended March 31, 1990 ("March 1990 10-Q"), Bancorp
recorded and reported as assets $5,618,000 purportedly
representing the value of eleven (11) RIWNs. In fact, the eleven
RIWNs had a value of no more than approximately $766,000, the
cash consideration paid by Bank for the first eight (8) of the
RIWNs. The inclusion of the RIWNs in the consolidated financial
statements, however, increased shareholders' equity by over 150%,
from approximately $3.3 million in 1988 to $8.35 million for 1989
and at March 31, 1990. In fact, Bancorp's shareholders' equity
had decreased materially in 1989 and at March 31, 1990.
The Court further found that the periodic reports were
materially false and misleading by improperly recognizing the
$1.968 in "development fees" as income upon the exchange of
consulting and success fees for three of the RIWNs. There were
no actual consulting fees paid to the Bank. Instead, the
consulting fees were simply added to the outstanding amount of
the loans made to the developer and "straw borrowers" by the
Bank. Moreover, the loans were structured so that all loan fees
and interest would be funded by lines of credit, requiring no
debt service by the borrowers.
Prior to resigning as auditors in May 1989, DH&S had
determined that the upfront consulting fees could not be
recognized as income because the fees were "inextricably linked"
to the loans. DH&S had also determined that the loan arrangements
constituted a joint venture, and as such, the consulting fees
were "equity kickers" (i.e., an advance payments against overall
expected residual profits). As such, income recognition was
impermissible.
Therefore, the Court concluded that the Bank's recording of
these development fees, merely by swapping unearned consulting
and success fees for three RIWNS, resulted in a material
overstatement of pretax income of $18,146 (instead of a loss of
approximately $2 million).
Thus, the Court held that defendants Sands and Bancorp
violated Section 10(b) of the Exchange Act and Rule 10b-5
thereunder. Moreover, the Court held that defendant Bancorp
violated Section 13(a) of the Exchange Act and Rules 12b-20, 13a-
1 and 13a-13 thereunder. Further, the Court held that defendant
Sands was liable with and to the same extent, under Section 20(a)
of the Exchange Act, as the Bancorp for these violations.
See also Exchange Act Release No. 33296, Accounting and
Auditing Enforcement Release No. 511; and Litigation Release No.
==========================================START OF PAGE 5======
14051, Accounting and Auditing Enforcement Release No. 549
(April 13, 1994).
3. THE CERTIFICATES OF DEPOSIT ISSUED BY THE NATIONAL Bank
OF LIBERIA
a. False and Misleading Periodic Reports
In a further attempt to cure the Bank's and Bancorp's
deteriorating capital base and to relieve pressure from bank
regulators, defendants Sands, Geiger and Bancorp obtained six
unfunded certificates of deposit issued by the National Bank of
Liberia ("NBL") with face value of $3 million, for which these
defendants agreed to swap an additional 100 shares of Bancorp's
perpetual preferred stock.
The Court found that, in 1990, Bancorp filed periodic
reports with the Commission which contained materially false and
misleading statements about the value of the six CD's and the
transaction in which Bancorp acquired them. In the consolidated
financial statements contained in its 1989 10-K and March 1990
10-Q, Bancorp reported as an asset the $3 million face value of
six CD's. In fact, the CD's had a value of zero; they were never
funded by NBL or by any other entity.
By recording and reporting the six CD's as assets of $3
million, the defendants not only overstated working capital from
operations for year-end 1989, but in addition, inflated
shareholders' equity by 57% -- up from $5.3 million to $8.3
million.
The Court held that defendant Sands and Bancorp had violated
Section 10(b) and Rule 10b-5 of the Exchange Act because, prior
to filing the 1989 10-K and March 1990 10-Q, Sands and Bancorp
knew or were reckless in not knowing that the six CD's had no
value, but permitted the filing of false periodic reports anyway.
The Court also held that defendants Sands and Bancorp
violated Section 13(a) of the Exchange Act and Rule s 12b-20,
13a-1 and 13a-13 thereunder for the material omissions and
misstatements. Defendant Sands was further held liable, under
Section 20(a) of the exchange Act, with and to the same extent as
defendant Bancorp.
[See Exchange Release No. 33296; Accounting and Auditing
Enforcement Release No. 511. See also Exchange Act Release No.
33294; Accounting and Auditing Enforcement Release No. 509.]
b. The Offer to Sell Liberian CDs
The Court found that, from January through May 1990,
==========================================START OF PAGE 6======
defendants Bancorp, Sands and Geiger, together with defendant
Dass, acting through defendant Apex, attempted to sell all forty
(40) of the unfunded CD's both within the United States and
abroad. This included the six CD's acquired by Bancorp.
The Court first concluded that a Liberian CD was an evidence
of indebtedness and thus a "security" because, among other
things, investors were not accorded the same level of protection
provided to CDs issued in the United States; Liberia was
virtually bankrupt and had been blacklisted from the IMF; and
Liberia was experiencing a civil war.
The Court then found that defendants Bancorp, Sands and
Geiger, when offering the CD's for sale, knew that the CD's had
no value. Nevertheless, they made materially false and
misleading statements, and omitted material facts, regarding the
CD's to the investing public.
Accordingly, the Court held that defendant Bancorp violated
Section 17(a) of the Securities Act. Defendant Geiger had yet to
be tried on these same allegations.
4. RELIEF
Even though the conduct occurred in 1987 through 1990, the
Court held that injunctions were appropriate against defendants
Sands, Bancorp and PacVen. The Court found evidence of a high
level of scienter in this case, numerous violations of the
federal securities laws, including a pattern of untimely filing
of periodic reports and reports which contained numerous
materials misstatements or omissions, and the lack of recognition
of any wrongdoing.
The Court also found defendant Sands substantially unfit to
serve as an officer or director of a public company. The Court
found that Sands engaged in conflicts of interest, breached his
fiduciary duties to the shareholders of both Bancorp and PacVen,
made false representations to auditors, denied auditors access to
crucial information, extracted large fees (both legal and
consulting) from the Bank under a management service contract
between the Bank and the Bancorp, received interest payment on
the debentures he unlawfully purchased, and engaged in a pattern
of late and misleading filings. Accordingly, Court held that
defendant Sands, though a lawyer, should be permanently and
unconditionally barred from ever acting as an officer or director
of a public company.
Further, defendant Sands and Bancorp were jointly and
severally ordered to make restitution of $688,000 in connection
with their fraudulent funding of the 1987 Bancorp offering. That
amount represented the $500,000 diverted from PacVen, and the
$188,000 raised from the public. The Court also ordered
==========================================START OF PAGE 7======
prejudgment interest from the date of December 1987, the closing
of the Bancorp offering, to date of entry of judgment.
See also Litigation Release No. 13904 (December 14, 1993);
and Release No. 1401 (April 13, 1994).